Question

During 2013, a construction company changed from the completed-contract method to the percentage-of-completion method for accounting purposes but not for tax purposes. Gross profit figures under both methods for the past three years appear below:

Completed-Contract Percentage-of-Completion
2011 $ 475,000 $ 700,000
2012 625,000 950,000
2013 700,000 1,050,000
$1,800,000 $2,700,000
Assuming an income tax rate of 40% for all years, the affect of this accounting change on prior periods should be reported by a credit of
a. $540,000 on the 2013 income statement.
b. $330,000 on the 2013 income statement.
c. $540,000 on the 2013 retained earnings statement.
d. $330,000 on the 2013 retained earnings statement.

Answer 1

The effect of the construction company changing its accounting method on prior periods should be reported as a credit of $540,000 on the 2013 retained earnings statement, reflecting the after-tax cumulative difference between the two methods from 2011 to 2013.

Step-by-step explanation:

The question involves a construction company that changed its accounting method from the completed contract method to the percentage-of-completion method. The effect of this change on prior periods would be reflected in a cumulative effect adjustment in the year of change.

The cumulative difference in gross profit figures between the completed-contract method and the percentage-of-completion method from 2011 to 2013 is $900,000 ($2,700,000 - $1,800,000). Considering a tax rate of 40%, the net effect would be $900,000 - 40% of $900,000 = $540,000. Since this adjustment relates to prior periods, it should be reported as an adjustment to the beginning balance of retained earnings, not on the income statement.

Therefore, the correct answer would be a credit of $540,000 on the 2013 retained earnings statement.